This is a supplement to our post from last week. This installment summarizes changes that will affect business taxpayers. If you missed the post that describes changes that affect individual taxpayers, then you can find it here.
By now, you’ve likely heard that major changes are coming to the tax code in 2018. As one of its final acts before adjourning for the year, the House of Representatives passed House Resolution 1, known as the “Tax Cuts and Jobs Act” (the Senate passed its version of the law earlier in the year). With the President’s signature, the Act has become law.
The Act revises the Internal Revenue Code is a variety of ways, and is the most comprehensive tax reform measure since 1986. We know you are wondering how the changes will affect your business. Here is a summary of changes affecting businesses in 2018 and later.
Corporate Tax Rates Reduced
For years beginning January 1, 2018, the corporate tax rate will be a flat 21%, and the corporate alternative minimum tax (AMT) is repealed.
Who is affected: Corporations, including partnerships and LLCs that have elected treatment as a corporation (but not S corporations)
What it means: Except for the smallest corporations, which received a 15% rate under pre-2018 law, taxes will decline by between 4% and 14%. However, the new law also includes a reduction in the dividends received deduction (of either 15% or 20%, depending on the kind of dividends). Thus, some corporations (especially small corporation) with dividend paying investments could see an increase in tax under certain circumstances. Note that the new law made no changes to the Personal Holding Company tax applied to certain corporations, so treatment as a corporation is still not a good way to subvert higher individual tax rates.
New Deduction for Pass Through Income
For tax years 2018 through 2026, non-corporate taxpayers, including estates and trusts, with qualified business income from a partnership, S corporation, or sole proprietorship, may deduct 20% of qualified business income.
Who is affected: Small businesses that have elected pass-through taxation, including service businesses (law firms, accounting firms, etc.) with income of less than $415,000
What it means: Subject to a complicated set of rules, small businesses taxpayers will simply pay less tax. For example, a sole proprietorship with net income of $200k in qualified business income for 2018 will pay approximately $10k less in federal income tax in 2018 than in 2017.
Capitalization and Depreciation Rules to Change
This one has a few pieces:
- For property placed in service on or after January 1, 2018, the Code Section 179 expense deduction for long-lived property is permanently increased to $1MM (from $500k), and indexed for inflation. The deduction is also expanded to include improvements to certain non-residential real property that was previously had to be capitalized and depreciated (roof, HVAC, fire suppression, and security systems) after the date the property was first placed in service.
- For qualified property placed in service between September 27, 2017, and January 1, 2023, business taxpayers may claim a 100% first year deduction for the adjusted basis of the property (commonly called bonus depreciation, and previously limited to 50%). This deduction is not to be confused with the Section 179 expense deduction, which is subject to a separate set of rules, the most important of which is that it cannot be used to generate a net operating loss.
- The depreciation limits for luxury automobiles placed in service on or after January 1, 2018 are increased.
- Computer equipment is no longer considered “listed property” under Code Section 280F, which means that taxpayers are no longer required to meet heightened substantiation requirements for expensing computer equipment.
- Separate definitions for leasehold improvement, restaurant, and retail improvement property are eliminated, and all qualified improvement property is subject to a 15-year recovery period (even when subject to a shorter use period under a lease).
Who is affected: Any business that purchases property for business use
What it means: These measures don’t reduce tax, per se, but they change the timing for when tax is due. By accelerating expenses associated with property, businesses can take deductions earlier, reducing tax in years when new property is acquired. For rapidly growing companies, this is a good thing. However, bringing these deductions forward means that they won’t be available in later years to reduce income. Mature companies that aren’t continuously adding or replacing property will see less benefit from these changes. Also, accelerated depreciation and expensing of long-lived assets will widen book to tax differences for taxpayers who use GAAP basis financial reporting. Bonus depreciation and Section 179 expense treatment are generally not allowable under GAAP.
Employer’s Deduction for Fringe Benefit Expenses Limited
For amounts paid or incurred after December 31, 2017, the following deductions are permanently altered or disallowed:
- Entertainment expenses are disallowed, without regard for whether they had a business purpose.
- The deduction for meals provided for the convenience of the employer (e.g. in employee cafeterias) is reduced from 100% to 50% until 2026, after which it disappears altogether.
- The deduction for employee parking or transportation is disallowed (but those benefits remain tax-free to the employee).
Who is affected: Employees of companies with generous fringe benefits, especially professional services firms and startups
What it means: Employer provided meals and parking probably won’t go away, but the reduction in tax benefits will likely result in less generous benefits offered by employers in the future. Certain employees in occupations where meals and entertainment are common or required expenses (sales people, workers in remote places like oil rigs) may receive more base pay with the expectation that some part of that employee’s compensation be used to cover disallowed expenses.
Capitalization Soon Required for Research or Experimentation Expenses
For amounts paid or incurred in tax years beginning after December 31, 2021, R&E expenses related to software development and other “specified R&E expenses” must be capitalized and amortized over a five-year period (15 years if such activities are conducted outside the U.S.).
Who is affected: Development and growth stage companies with substantial software development expenses, or other specified R&E expenses
What it means: Affected companies will no longer be eligible to full deduct research costs in the year incurred. However, many early stage companies have little or no income, so the requirement to capitalize and amortize may not actually increase tax. This may affect the way the R&D Tax Credit is calculated for future years. However, the long lead time before this measure goes into effect suggests that it might be a target for future repeal.
Interest Expense Deduction Limited: For tax years beginning after December 31, 2017, and before January 1, 2022, the business interest deduction is generally limited to 30% of a company’s adjusted taxable income. Disallowed amounts may be carried forward to future years. Companies with adjusted income of $25MM or less are not subject to this limitation.
Net Operating Loss Carryback Eliminated: For NOLs arising in tax years ending after December 31, 2017, the two-year carryback is repealed (this also affects individual taxpayers). Additionally, the deduction for a NOL carryforward is limited to 80% of taxable income in any future year. Under pre-2018 law, the NOL carryback requirement could be waived, at the taxpayer’s discretion, which meant that taxpayers with NOLs could decide whether carrying forward or back would produce the better result. Starting in 2018, that option is no longer available.
Domestic Production Activities Deduction Repealed: The Code Section 199 deduction for domestic production activities is eliminated. This deduction was generally not available to companies that didn’t manufacture physical products, so it was not common among small business taxpayers. Some companies may pay more tax, but the vast majority won’t notice its absence.
Like-Kind Exchange Treatment Limited: The election to defer gain from the sale of qualified business or investment property under Section 1031 is now permitted only for real property transfers. Contrary to popular belief, this measure was not targeted at virtual currency traders, though it isn’t clear who it was intended to affect. Section 1031 offered a few legitimate use cases besides real property (e.g. fully depreciated, but still serviceable machinery, and cattle), but likely wasn’t in common use for those purposes.
These are only the highlights of changes to the tax code that will affect businesses in 2018 and later. If you have any questions about the new law as it applies to your situation, please get in touch with us.